From 'boys to men': Tier 2 IT cos deliver eye-popping returns — what's behind the rally?

In the last three, six and twelve months, the Nifty IT index has marginally underperformed the broader Nifty50 index, but midcap and smallcap stocks have outrun all indices on their radical transformation from 'boys to men', said Nuvama Institutional Equities in a report, adding that some quality tier two IT companies have delivered eye-popping returns.

While Nuvama has picked LTIMindtree, Coforge and Persistent Systems as its top picks in the midcap IT sector, the brokerage has also initiated coverage on Mphasis with a 'Reduce' rating on relatively expensive valuation.

Shares of LTIMindtree have rallied 33%, Persistent Systems 62%, Coforge 48%, and Mphasis 23% so far this year. In comparison, the Nifty50 and the Nifty IT index have gained 15% and 17% on a year-to-date basis.

Nuvama said this is a remarkable dichotomy of the IT services sector. The brokerage remains positive on select quality tier two IT companies, and the IT sector at large.

Nuvama argued the outperformance of midcap IT firms is rooted in their radical transformation—a coming of age from 'boys to men', having attained a critical size that passes muster on bidding for large deals.

Aditionally, their margin profiles have undergone a reset and businesses are much more diversified, the brokerage said, terming this factor as "no less significant".

Currently, all the CLAMP (Coforge, LTIMindtree, Mphasis and Persistent) companies are trading at significant premium to tier one players—a sharp contrast to the historical trend, Nuvama noted.

The brokerage believes the market is ascribing a premium as the CLAMP are no longer the mid-cap companies of yesteryears and are also likely to report superior sustainable growth over the next three–four years.

Nuvama expects the valuation premium to hold in the near-to-medium term because of the growth outperformance and business transformation of tier two IT companies.

The select quality tier two CLAMP companies have a story of unique business transformation, the brokerage said.

"The common thread running through them is how their business models evolved to surpass those of larger peers. Courtesy their 20%-plus revenue CAGR over FY21–23, each of the CLAMP companies clocked $1billion-plusin revenue and a headcount of 20,000-plus. This makes the cut for most deals. They have also diversified their business profiles, and no longer rely on a single vertical/client," it said.

With the Covid-dust settling, the FY25 margins of most tier one IT firms will likely wane to pre-covid levels or even lower, Nuvama said. "CLAMP companies, in contrast, overhauled their businesses during covid (utilisation, offshoring, hiring), and can sustain margins at levels similar to (or even higher than) during the pandemic," it said.

The brokerage added: "We see glaring similarities between LTIMindtree/Coforge and Infosys/Cognizant of yesteryears, and see these companies traverse the path of these larger peers."